Europe’s Welcome Pandemic Response

Although the sudden stop imposed by COVID-19 is having far-reaching consequences for European Union economies, the EU's policy response has already far surpassed its efforts to mitigate past crises. Europe may not be out of the woods yet, but it is clearly on the right path.

PARIS – The COVID-19 pandemic has hit EU member states hard, and will continue to confront the bloc with significant economic challenges. Yet, from a macroeconomic perspective, Europe’s policy response so far has been encouraging, because it includes strong incentives for sustainable growth, solidarity, and economic stability.

European governments have committed to pursuing unprecedented fiscal measures in response to the crisis, and – equally important – markets seem to have deemed these measures appropriate. Recent sovereign-debt offerings by Portugal and Italy were priced at very low rates and were largely oversubscribed. Across Europe, sovereign-bond yields are similar to what they were at the end of 2019. Although spreads and credit-default-swap pricing on certain European governments’ debt have widened, they are nowhere near the levels seen in previous shocks. In other words, the fragmentation of European financial markets is much more contained than it was in 2009 or 2012.

Moreover, there are good reasons to believe that the COVID-19 policy response will play out differently than the one that followed the 2008 financial crisis, even though the recession might be deeper this time. S&P’s forecast anticipates that GDP will contract by 6% in Germany, 8% in France, and 10% in Italy this year, and that debt-to-GDP ratios will soar as a result of the recession and the unprecedented fiscal response.

However, from a macroeconomic perspective, debt-to-GDP levels do not reveal much about debt sustainability if taken out of context and treated as static. A more telling and dynamic indicator is the oft-overlooked three-band interplay between a country’s primary budget balance, its interest burden, and its economic growth rate.

Though government debt-to-GDP levels will rise in 2020, those increases will reflect a one-off fiscal response to a unique non-economic shock. Unlike the events leading to the 2008 crisis, which started in the financial sector, the COVID-19 pandemic is first and foremost a health crisis, albeit one with far-reaching economic implications, including higher unemployment, lower asset prices, higher default rates, and more non-performing loans.

S&P’s current base-case outlook for the third quarter of 2020 through 2021 anticipates that once the pandemic lockdowns end, growth will resume and once again exceed real interest rates. Hence, we expect economic rebounds of more than 4% in Germany, and of more than 6% in France and Italy. In this scenario, primary budget balances would improve, and debt-to-GDP levels would decline across most European countries. Equally promising for Europe’s recovery, interest rates on European government debt have fallen by some 400 basis points since the global financial crisis, while per capita GDP has grown by 5%.

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Another positive sign is the composition and sequencing of today’s policy response, which is quite different from previous crises. As some commentators have noted, during the 2008 crisis, precious time was lost debating issues such as European ring-fencing and the details of new policy instruments. Whereas the US Federal Reserve launched its first quantitative-easing program in 2008, it took the European Central Bank another seven years finally to expand its balance sheet and start its own QE program.

This time, the policy response has been much faster, as well as generous and consistent with the best economic theory. Within a month of most nationwide lockdowns, the ECB’s balance sheet had already expanded by €500 billion ($540 billion), equivalent to 4% of eurozone GDP. And while much more remains to be done, the current trajectory and scale of the fiscal and monetary expansion offers hope that the pandemic’s blow to GDP will be a short-term phenomenon.

To be sure, some would argue that the EU does not do enough to support distressed governments, or to close the divide among EU member states. The EU is yet to have its “Hamilton moment” of fiscal transfer, and a common treasury probably will not come anytime soon. Still, it is not as though the EU has spent the current crisis auditing public accounts or caviling over the Stability and Growth Pact. On the contrary, it very quickly relaxed its budget rules and guidelines on state aid, thereby allowing member states to support their economies and health systems as needed.

Moreover, EU finance ministers have devised a safety-net mechanism through which the EU budget will be made available to fund partial employment benefits, thus softening the painful fiscal shock at the national level. The EU also is considering using the European Stability Mechanism to fund national health-care expenditures, which would provide still more short-term relief.

Taken together, these quick policy actions indicate that the EU’s response is already miles ahead of its reaction to previous crises. And at the European Council, EU heads of state and government agreed to work toward establishing an EU recovery fund to shore up the member states’ economic prospects. The lessons learned from the so-called Juncker Plan establishing a European Fund for Strategic Investments will be useful in laying the foundations for a fund dedicated to post-pandemic recovery.

COVID-19 will undoubtedly leave its mark on European economies. National GDPs will not return to their late-2019 levels for at least two years, and that could have implications for credit. But if the EU recovery plan that is now under discussion turns out to be bold, forward-looking, and appropriately aligned to other growth-friendly programs such as the European Green Deal, it could help European economies become more sustainable, competitive, and cohesive far into the future.

The views expressed in this commentary are the author’s own, are not policy recommendations, and are not predictive of rating actions by S&P Global Ratings.

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Actually, post-mortems will probably conclude that the greatest virtues of Europe's response to this latest crisis was not so much that it was larger and quicker than in previous cases, but that it was not so large or so quick as the American response. Remember, the Americans and the Europeans were both reacting to self-inflicted wounds: decisions to lock down their economies in the face of a disease that ultimately proved to be far less lethal than they expected, but far more contagious than their lock-downs could handle. Antibody testing in California, New York, Germany and elsewhere has clearly indicated that the virus has spread 10 to 15 times more quickly than the official case count would indicate, despite the lock-downs. In fact, in New York, in particular, acquired immunity, rather than its lock-down, has probably been the major factor in slowing the spread of the disease.

In contrast to public health organizations, however, public financial organizations were primed to respond to a crisis because of their experience in 2008-09, their familiarity with the growing fragility of financial markets, and a growing indifference to the scale of public debts. So public financial authorities responded quickly, before the most critical features of the disease were even known. Americans, in particular, added $2.7 trillion to their federal debt on top of deficits that are already running above $1 trillion annually. Meanwhile, the Federal Reserve added several trillion dollars to its balance sheet over a matter of weeks.

In short, it appears that financial authorities in western countries ran laps around the public health authorities in responding to the coronavirus. Money was out before the public health strategy of lock downs had even been checked through random antibody tests. It now appears that the coronavirus is not very lethal; it also appears to be far more contagious than lockdowns can handle. That's all good to know. But it would have been far better if those facts had emerged before we all, Europeans as well as Americans, were on the hook for several trillion dollars in new debt.

Its a well-written piece and some of what you point out is broadly relevant

However the fact remains that absent a decisive - by this I mean several Trillion - intervention in the form of long-dated bonds, or else money-finance stimulus, co-ordinated at pan-EU level, there is no chance of a swift revival

The ECB stance to date - more Q E plus a few other treats - wont succeed as it is not directed at the micro-level which requires massive boosting

Equally the recent programs announced at EU level are insufficient as they are optional, not cash-based and dependent on demand / co-investment

Debt sustainability issues will become apparent once the embedded nature of the shock hits headline figures and trickles down causing a self-perpetuating cycle

We better all strap in as this is a long painful road back to "normality"

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